CareFirst Aid

Peter H. FrankTHE BALTIMORE SUN

It came with shocking swiftness. On a Thursday night, Feb. 21, regulators took over CareFirst.

It didn't seem quite possible. CareFirst was the only major health maintenance organization in Baltimore consistently reporting earnings each year. The HMO's financial statements showed a strong net worth. And revenues had been growing, year in, year out.

Suddenly, though, the state's Insurance Division said CareFirst was more than $7 million in the hole. David D. Wolf, the company's chief executive for six years, had been fired. CareFirst's bank accounts were frozen. A proposed sale was in the works. Bankruptcy had become a serious threat.

To the outside world, the collapse of what once had been the highest-flying, newest wave in the local health insurance scene occurred with no warning. Even some top officials at the company had little idea what was happening.

To those in charge at CareFirst, however, it had been a long, painful and rancorous time coming. Enormous debt, missed payments, shrinking membership and growing animosities among directors culminated in a financial collapse and a boardroom coup that ultimately forced the hands of regulators.

What happened at CareFirst was more than just a mid-1980s leveraged buyout gone bad.

No other soured LBO had the medical care of 118,000 people -- mostly Marylanders -- hanging in the balance. Few were able to hide their problems so well for so long. And few CEOs were reinstated as regulators took control of the insolvent companies.

Indeed, Mr. Wolf, who declined to be interviewed for this article, has come through his company's failure with his career and reputation on the rise. He could even be heading a larger HMO network before it's all through.

Peers and regulators describe the 40-year-old Baltimore native as an honest and competent executive. Blue Cross and Blue Shield of Maryland, which courted the ailing HMO for a year and appears to have finally bagged its prize, has promised Mr. Wolf that he will stay on if the deal goes through.

How did Mr. Wolf, a promising young accountant-turned-medical-executive, survive phoenix-like as his company turned to ashes during the past few weeks? Was it a well-wrought plan or plain luck?

What apparently saved Mr. Wolf was the same thing that helped bring down his company.

A complex corporate structure helped shield the HMO's financial performance from its increasingly troubled parents. A highly secretive ownership structure helped keep the company's problems out of the public eye. And board in-fighting, which led to a threat of bankruptcy and spurred the regulators' action, kept the spotlight of blame on others while Mr. Wolf picked up the pieces.

Through a series of interviews with top CareFirst officials, regulators and other industry players, a picture of an HMO succumbing to financial illness develops. Most, however, declined to be identified by name, citing the delicate nature of the pending sale of CareFirst to Blue Cross and the likelihood that the HMO would continue operating under Mr. Wolf's direction.

From the beginning, CareFirst had an unlikely combination of owners. It was born in 1978 -- at the start of the HMO industry -- through the concerted efforts of unions, management and doctors.

The idea behind the business was rather simple. Medical costs were rising, and the federal government was looking for ways to hold the expenses in check. HMOs, using a technique called managed care, appeared to be an answer.

Instead of paying a doctor's bill after procedures were performed on a patient, these managed-care companies would find doctors willing to treat members for a set monthly fee.

If a doctor was receiving a set amount each month per patient, the doctor might think twice about prescribing unnecessary tests -- or so the reasoning went. In addition, while HMOs typically picked up hospital costs for their members, doctors were forced to use their monthly payment to cover the costs of sending their HMO patients to specialists.

Within a few years, however, CareFirst was hurting badly. The company did not have the money to expand its operations in the face of growing competition and increasing costs.

In 1984, a New York investment firm, Adler & Shaykin, agreed to buy out the owners of CareFirst for roughly $3.5 million. Within months, in January 1985, Mr. Wolf was hired.

At 34, Mr. Wolf had already done well. A graduate of Overlea High School, he enrolled in Loyola College, where he earned a bachelor's degree in accounting in 1972 and an M.B.A. in finance in 1977. At the Coopers & Lybrand accounting firm, he rose quickly. By 1978, he was wooed away to run the administrative end of the largest physicians' group in the state, Chesapeake Physicians P.A.

As chief administrative officer and chief financial officer of the group's professional liability insurance company, Mr. Wolf worked closely with CareFirst. The HMO had been started with the help of the doctors he worked for, and roughly 85 percent of the services needed by CareFirst members were provided by Chesapeake, said Richard E. Horman, who was brought in as chairman and chief executive by Adler & Shaykin.

"Dave was bright and energetic and seemed to have talent," Dr. Horman said. "I thought he had the making of a good CEO . . . ."

By 1986, CareFirst was booming. The company had more than quadrupled to nearly 80,000 members and was consistently profitable. Revenue had grown to $50.9 million in 1986 from $4.6 million just two years earlier. Net income increased nearly eightfold, to more than $2 million, during the same period. It was for Adler & Shaykin the chance to cash out on its investment.

Mr. Wolf, a group formed by CareFirst management, some local doctors and other investors led by Baltimore lawyer Isaac M. Neuberger seized the chance to catch the rising tide that was the HMO industry. The group formed CareFirst Inc. and bought HealthCare Corporation of America (HCCA), which owned the CareFirst HMO. By borrowing heavily from Maryland National Bank and others, the new owners were able to come up with the purchase price, more than $30 million.

Mr. Wolf was now firmly situated at the head of the fastest-growing and most profitable HMO in Baltimore. Expanding throughout Maryland, CareFirst would soon have its eye on Washington, Pennsylvania, Delaware and Virginia.

In 1987, the company hired Bear, Stearns & Co. to find permanent financing to pay off the short-term debt used in the purchase. Venture capital firms stepped in and ended up with about half the company's stock.

The next year, HCCA took a big step toward its goal of spreading "from Richmond to Southern Pennsylvania," as Mr. Wolf would describe it later, when the company bought two failing HMOs in Maryland and northern Virginia.

By the end of the year, the current HMO structure was set. HCCA owned three HMOs: HealthCare Corporation of the Mid-Atlantic, operating as CareFirst; HealthCare Corporation of the Potomac, operating as Potomac Health; and Physicians Health Plan Inc., operating as Physicians CareFirst.

The decision that would haunt the company was yet to come.

In mid-1989, the three HMOs were joined by a fourth HCCA subsidiary: HCCA Services Inc. The new affiliate was used as a type of corporate repository, receiving from the HMOs various equipment, notes issued by HCCA and millions of dollars in debt. The HMOs signed a long-term management contract with their newly created sister company and began paying the affiliate for virtually all administrative work and claims payment services previously handled by the HMOs themselves.

The structure allowed the company to shift assets and debts and keep the highly regulated books of the HMOs relatively clean. But it did another thing, too: It furthered a secretiveness about the company's ownership and structure that permeated the company.

Directors at one level of the organizational ladder have not been told who sits on the board above them. And they have been ill-informed of their parent's financial condition. The news of the state's action against CareFirst and its two affiliated HMOs stunned some directors at the company. When told that state regulators had frozen the HMOs' assets last month, one director said, simply, "Dear sweet Jesus."

Regulators, who monitor the financial results of the three HMOs every three months, do not have jurisdiction over the financial statements of the HMOs' parent companies and do not regulate non-insurance operations such as HCCA Services.

But it was thanks to its multi-layered structure, in large part, that the company was able to continue for so long. Because it was HCCA that was being squeezed by the debt load, the HMO subsidiaries were free to operate without the increasingly troubled financial condition of its parent showing up on their books.

Nevertheless, serious problems were mounting.

The first signs of internal troubles began showing last spring, according to company executives. The board, worried by the appearance of a conflict of interest, decided to drop Mr. Neuberger's law firm as the company's legal representative. An earlier consideration of selling stock to the public had been scrapped, and rumors about the company's sale began circulating. Potential suitors, including Aetna Life & Casualty Co. and Blue Cross, were knocking on the company's door.

And the coming financial problems were evident. A payment to Maryland National Bank for somewhere between $4 million and $6 million of the total $22 million in debt was coming due in midsummer. It was becoming clear that the company would not have the money.

Early prices for the company, which had reached above $80 million, were beginning to fall as market conditions changed and the HMOs started faltering. As revenues continued to climb, thanks to rate increases, membership was dropping for the first time since Mr. Wolf arrived. Relations among directors were strained.

"As a bystander, it was amazing to watch the finger-pointing and recriminations that went on when the house of cards began disintegrating," one company official says, referring to the HCCA board.

The debt owed by HCCA -- about $43.5 million as of early February -- was not being paid. Mr. Neuberger was owed $8 million. The venture capital firms

were owed $13.5 million. And the $22 million owed to Maryland National had accrued an additional $3 million in interest.

An examination by the state's Insurance Division had determined that more than $20 million in assets and medical claims that had been shifted off the HMOs' books and onto the balance sheet of HCCA Services should be moved back to the HMOs. The result was disastrous.

On Feb. 6, having finished their examination, state regulators told the companies the HMOs were financially impaired. Instead of having a positive net worth of $12.4 million as of June 30 -- the financial statement studied by the examiners -- the CareFirst HMO, for example, actually had a negative net worth of $7.1 million, regulators said. That placed the company $9.1 million under what the law required.

Potomac Health suffered a similar revaluation, and two days later Virginia regulators reached the same conclusion about Physicians CareFirst. The three HMOs combined needed more than $12 million to meet required capital levels.

The day before Virginia regulators acted, the three venture capital firms had played what appeared to be their ace-in-the-hole. Written into the debt agreements between these noteholders and the company was a provision that should the company default on their debt -- which apparently had occurred -- these investors had the right to elect two additional directors. Capitalizing on that provision, the venture capital firms took control of the board, with five of nine seats.

OC The next day, Feb. 8, Maryland Insurance Division officials met

with CareFirst executives. The company was presented with an eight-point plan, including 30 days to work out of the situation. Regulators, typically loath to force insurance companies out of business and alarm the public, were trying to salvage what remained.

A week later, Andrew M. Paul, an HCCA director and general partner of a venture capital firm that had invested in the company, met with the Insurance Division. Suddenly, the assurances of the company had changed, John A. Donaho, the Maryland insurance commissioner, said. No longer was the board abiding by some of the conditions. Beyond that, the worst was mentioned: the B-word -- bankruptcy.

Although it remains arguable whether an HMO company can legally file for bankruptcy in Maryland -- an earlier case involving another HMO was thrown out by the courts years ago -- the threat touched a nerve with regulators.

"We, in our best judgment, had to act promptly to protect the 118,000 members," Mr. Donoho said.

Within hours, the papers had been filed and a judge's signature was on a court order to freeze the HMOs' assets. Phone calls to lawyers, the governor's office and regulators in other states were flying. Blue Cross checked in to reiterate its offer.

"Since I was not able to convince the owners of these companies to make an infusion of capital," Mr. Donaho said in a statement, "I was forced to file these orders in the interest of the members."

By the next day, CareFirst's bank accounts at Maryland National had been frozen. Regulators were in charge of the HMOs' money pending a court hearing to determine whether they could take final control of the plans. The hearing, delayed twice, has been scheduled for April 1.

And in less than a week -- on the evening of Sunday, Feb. 24 -- Blue Cross reached agreement with CareFirst executives. Instead of the $80-million-plus price tag of a year earlier, Blue Cross had come up with a plan to pay off creditors in cash and restore the HMOs' required financial condition for roughly $25 million.

Regulators have studied the deal and are expected to make a decision this month. Blue Cross said it would run the CareFirst operations as an affiliate to its Columbia-FreeState Health System, the largest HMO in the Baltimore area. If Blue Cross succeeds, the state's largest health insurer would suddenly also lead the biggest HMO conglomerate in this region. Total membership could jump to nearly 300,000 with the combined companies.

And rather than labeling Mr. Wolf a scapegoat, Blue Cross has praised him. Mr. Wolf, who has since been rehired along with Mr. Chaney, could be in line to oversee Blue Cross' entire managed-care operations.

Blue Cross said last week that it was premature to discuss any consolidation of CareFirst and Columbia-FreeState.